Beginner's Guide To Call Buying

The popular misconception that 90% of all options expire worthlessly, frightens investors into mistakenly believing that if they buy options, they'll lose money 90% of the time. But in actuality, the Chicago Board Options Exchange (CBOE) estimates that only about 30% of options expire worthless, while 10% are exercised, and the remaining 60% are traded out or closed by creating an offsetting position.

Key Takeaways

Buying calls and then selling or exercising them for a profit can be an excellent way to bolster your portfolio's overall performance.

Investors most often buy calls when they are bullish on a stock or other security because it affords them leverage.

Call options dramatically reduce the maximum loss potential an investment may incur, unlike stocks, in which the entire value of the investment may be lost, should the share price dip to zero.

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Call Buying Strategy

When you buy a call, you pay the option premium, in exchange for the right to buy shares at a fixed price by a certain expiration date. Investors most often buy calls when they are bullish on a stock or other security because it affords them leverage.

Consider the following example: let's assume that XYZ stock trades for $50. Let us further assume that a one-month call option on the stock costs $3. This presents a choice: would you rather buy 100 shares of XYZ for $5,000 or would you rather buy one call option for $300 ($3 x 100 shares), considering the payoff depends on closing prices one month from now? Still confused? Consider the following graphic illustration of the two different approaches:

As you can see, the payoff for each investment is different. While buying the stock will require an investment of $5,000, you can control an equal number of shares for just $300 by buying a call option. Also note that the breakeven price on the stock trade is $50 per share, while the breakeven price on the option trade is $53 per share (not factoring in commissions or fees).

While both investments have unlimited upside potential in the month following their purchase, the potential loss scenarios are vastly different. Case in point: while the biggest potential loss on the option is $300, the loss on the stock purchase can be the entire $5,000 initial investment, should the share price plummet to zero.

Closing The Position

Investors may close out their call positions by selling them back to the market or by having them exercised, in which case they must deliver cash to the counterparties who sold them. Continuing with our example, let's assume that the stock was trading at $55 near the one-month expiration. Under this set of circumstances, you could sell your call for approximately $500 ($5 x 100 shares), which would give you a net profit of $200 ($500 minus the $300 premium).

Alternatively, you could have the call exercised, in which case you would be compelled to pay $5,000 ($50 x 100 shares) and the counterparty who sold you the call would deliver the shares. With this approach, the profit would also be $200 ($5,500 - $5,000 - $300 = $200). Note that the payoff from exercising or selling the call is an identical net profit of $200.

The Bottom Line

Trading calls can be an effective way of increasing exposure to stocks or other securities, without tying up a lot of funds. Such calls are used extensively by funds and large investors, allowing both to control large amounts of shares with relatively little capital.

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